Key Fed message got lost in the shuffle

With a shift in the Fed’s approach, the outlook for risky assets may have improved heading into 2020

Last week the US Federal Reserve cut rates by 25 basis points. Not much of a surprise there. Rate markets had been pricing in a cut with near certainty.

In the press conference, Fed Chair Jay Powell emphasized that the Fed is unlikely to cut rates any further because its benchmark funds rate is in a good place.

After a better-than-expected jobs report in October, a slew of Fed speakers, including the uber-dovish President of the Federal Reserve Bank of Minneapolis Neel Kashkari, indicated that the likelihood of a cut in December is looking quite low.

As you would expect, most investors have focused on that point and adjusted their expectations accordingly.

Unfortunately, this singular focus on future cuts has shifted the market’s attention away from a more important story: what will drive future Fed tightening?

In his press conference, Jay Powell made it clear that the Fed would not consider tightening without a significant increase in inflationary pressure. But not just any inflationary pressure. It must be persistent for the Fed to consider tightening.

I don’t know about you, but I believe this is an even bigger pivot by the Fed than when it changed course and stopped tightening in December 2018.

Think about it. Since this expansion began, the Fed has been thinking about the rate cycle in a very traditional framework. In the Fed committee members’ hearts, they never felt comfortable with low rates, and they always saw some inflationary problem around the corner even when it didn’t exist. It was this traditional thinking that got the Fed to start unwinding its balance sheet and raising rates aggressively in 2018, even though there was no actual or palpable inflation problem.

In this mistaken approach, not only did the Fed start tightening to fight the ghost of inflation, but it also suggested the rate hikes created room for it to CUT RATES in case a recession loomed. Again, in hindsight, a preposterous proposition, in my view. That is the equivalent of a person intentionally falling down the stairs to ensure that the ambulance will arrive in time if he or she has a heart attack in the future. You can see the perverse nature of the Fed’s thinking. But somehow the Fed’s members convinced themselves, and a lot of investors, that their decisions made sense when, of course, they didn’t.

A profound change for the Fed

Thankfully, Jay Powell threw this approach out the window.

The Fed will now only raise rates when it sees persistent inflationary pressure. It won’t do so when unemployment rates are persistently low, nor will it when the S&P 500* reaches a new high or other asset-prices rally. Inflation is the driving force for rate hikes, not anything else.

As I said before, this is a profound change in the Fed’s approach.

If global growth remains slow, as I suspect it will, inflationary pressures are unlikely to materialize, let alone be persistent enough to force the Fed’s hand. That suggests further activity is on hold. But if the economy weakens, the Fed will most likely cut rates. In other words, the future probability distribution of rates, or the range of possible interest rate levels in the future, just got truncated in half.

A risk on environment for 2020

These circumstances may have huge implications for asset prices going into 2020 and beyond, in my view.

With my forecast for rates to stay low, you can expect a modest reacceleration of the global economy. And with phase one of the US-China trade deal almost in hand, the outlook for equities should improve substantially. In my view, it’s time to consider buying stocks.

With the distribution of front-end rates truncated, the cyclical upside in long real rates has also gone down substantially. Furthermore, the potential cyclical rise in nominal rates is also limited as real rates and inflation are unlikely to go up meaningfully. That means credit assets remain attractive even at tight spreads. Furthermore, if US Treasury rates sell off by any significant amount in the cyclical upswing in 2020, Treasuries may also become a buying opportunity. Finally, as the growth reacceleration manifests itself, value stocks, especially banks, may do well for a bit. However, because of the low likelihood of rates breaking out in this new regime, that trend may not persist. As rates flatten out when the reacceleration fades, so too will prices on the value part of the equity market.

In an environment of a modest reacceleration in global growth, a reduced trade conflict and a cap on the upside in real US rates, the outlook for the US dollar deteriorates. The dollar may not weaken a great deal, but it is surely not going up by any significant amount. This scenario improves the outlook for International and EM equities, which are currently less expensive than US stocks, and it also may lead to a brighter picture for EM debt.

The bottom line, in my view, is relatively simple. The Fed regime has just changed, and the outlook for risky assets has improved. I think the outlook for asset prices in 2020 is RISK ON.

Important Information

* The S&P 500 Index is a market capitalization weighted index of 500 large US stocks.

Blog header image:  Orgnmaster / Getty Images

The opinions expressed are those of the author as of November 7, 2019, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.

These comments should not be construed as recommendations, but as an illustration of broader themes. Forward-looking statements are not guarantees of future results. They involve risks, uncertainties and assumptions; there can be no assurance that actual results will not differ materially from expectations.

Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa.

Invesco Distributors, Inc. is the US distributor for Invesco Ltd.’s retail products and collective trust funds, and is an indirect, wholly owned subsidiary of Invesco Ltd.

Krishna Memani serves as the Vice Chairman of Investments for Invesco. In 2009, Mr. Memani joined OppenheimerFunds, which became part of Invesco in 2019. Before he joined OppenheimerFunds, he was a managing director at Deutsche Bank, heading US and European credit analysis. Earlier, he headed global credit research at Credit Suisse; was in charge of high grade and high yield portfolios at Putnam Investments; and was a credit analyst at Morgan Stanley.

More in Market & Economic
The Fed gives stocks free rein to run. Can the rally continue?

Last week’s Federal Reserve (Fed) meeting proceeded largely as expected, but a very important development for stocks occurred during the follow-up press conference. As expected,...